TXU Electricity Limited (formerly known as Eastern Energy Ltd) v Office of the Regulator-General
[2001] VSC 153
•17 May 2001
| IN THE SUPREME COURT OF VICTORIA | Not Restricted | |
| COMMON LAW DIVISION | ||
No. 7669 of 2000
| TXU ELECTRICITY LIMITED (FORMERLY KNOWN AS EASTERN ENERGY LTD) | Plaintiff |
| v | |
| OFFICE OF THE REGULATOR-GENERAL | First Defendant |
| AGL ELECTRICITY LIMITED | Third Defendant |
| CITIPOWER PTY | Fourth Defendant |
| POWERCOR AUSTRALIA LIMITED | Fifth Defendant |
| UNITED ENERGY LIMITED | Sixth Defendant |
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JUDGE: | Gillard J |
WHERE HELD: | Melbourne |
DATE OF HEARING: | 9, 13-16, 19-21, 23, 26-30 March and 2-4 April 2001 |
DATE OF JUDGMENT: | 17 May 2001 |
CASE MAY BE CITED AS: | TXU Electricity Ltd v Office of the Regulator-General and Ors |
MEDIUM NEUTRAL CITATION: | [2001] VSC 153 Revised 14 June 2001 |
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Judicial Review – price fixing by Regulator – allegation made without power – question of law raised – meaning of Tariff Order – terms of art – evidence of meaning of words – application of Tariff Order – no error established – determination made within power.
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APPEARANCES: | Counsel | Solicitors |
For the Plaintiff | Mr W. Houghton QC with | Baker & McKenzie |
| For the First Defendant | Mr J. Beach QC with | Norton Gledhill and Gilbert and Tobin |
| For the Third Defendant | No appearance | |
| For the Fourth Defendant | Mr Richardson (solicitor) | Blake Dawson Waldron |
| For the Fifth Defendant | Mr M. O'Brien (solicitor) | Phillips Fox |
| For the Sixth Defendant | Mr S. Horgan | Deacons |
TABLE OF CONTENTS
Parties................................................................................................................................................... 2
The Nature and History of the Dispute......................................................................................... 4
Which determination?....................................................................................................................... 6
Judicial review jurisdiction.............................................................................................................. 9
Privative Clause................................................................................................................................ 14
Purely question of fact – no review?............................................................................................ 16
Price Fixing – Legislative Framework.......................................................................................... 17
Task Entrusted to Office................................................................................................................. 28
What do the words mean – clause 5.10(a)?.................................................................................. 33
"Price based regulation"............................................................................................................. 34
"Adopting a CPI—X approach"................................................................................................. 38
"Rate of return"............................................................................................................................ 42
Effect of clause 5.10(a)..................................................................................................................... 46
Did the Office make the determination without Power?......................................................... 65
· Having regard to the specific costs of each distributor...................................................... 74
· Determination is cost based and not price based................................................................ 75
· Use of building block approach contravened prohibited formula................................... 75
· The X factors should have been calculated on the basis of or having
regard to external variables.................................................................................................. 79
· The X0 was set without reference to the formula CPI—X.................................................. 80
· An efficient carry over would have been unnecessary if the X factors
were set on basis of external factors only........................................................................... 84
CONCLUSION................................................................................................................................. 86
HIS HONOUR:
This is the return of a summons in a proceeding instituted by originating motion in which the plaintiff seeks judicial review, pursuant to Order 56 of the Rules of Court, of a determination made on 21 September 2000 and a re-determination made on 1 December 2000 by the Office of the Regulator-General.
The plaintiff, TXU Electricity Limited ("TXU") complains that the Office had no power to make the determinations.
Parties
Prior to 1994, the electricity industry in Victoria was the responsibility of a statutory body called the State Electricity Commission ("SEC"). In that year, the State Government decided to privatise the electricity industry and sell off the various activities of the Commission to non-government bodies. The Government divided up the various parts of the SEC, formed companies to operate the various activities and proceeded to offer the new businesses for sale. They were sold during 1995‑1997.
The plaintiff, formerly known as Eastern Energy Limited, acquired one of the privatised businesses, and retails and distributes electricity in Victoria pursuant to licences issued under the Electricity Industry Act 1993 ("E.I Act").
This case is concerned with the distribution of electricity, that is, the ownership and operation of equipment used to transport electricity.
The first defendant, the Office of the Regulator-General ("Office"), is a body corporate created by the Office of the Regulator-General Act 1994 ("ORG Act") – see s.6.
One of the functions of the Office is to perform such functions as are conferred on it by relevant legislation under which a regulated industry operates.
One of the regulated industries is the electricity industry. The Office may regulate prices in respect of services supplied by a regulated industry – see s.24(1) – and was obliged by reason of the provisions of a Tariff Order, made pursuant to s.158A of the E.I Act, to fix the price for distribution of electricity for the period 2001 to 2005.
The Office made a determination and a re-determination, after an Appeal Panel Hearing in the year 2000, with respect to the prices for the distribution of electricity by, inter alia, TXU from 1 January 2001. The determination and re-determination are the subject of the present proceeding.
The case is concerned with the prices fixed for distribution of electricity for the period 1 January 2001 to 31 December 2005. Distribution is to be contrasted with generation and sale and is concerned with owning and operating the poles, wires, transformers, sub-stations and other infrastructure used to transport electricity.
The State of Victoria was joined as second defendant to the proceeding but by order made on 8 March 2001, I ordered that it cease to be a party to the proceeding. No relief was claimed against it.
The third, fourth, fifth and sixth defendants, AGL Electricity Limited ("AGL"), Citipower Pty ("Citipower"), Powercor Australia Limited ("Powercor") and United Energy Limited ("United Energy") respectively, are also, like TXU, the distributors of electricity in Victoria pursuant to licences issued under the E.I Act.
When the hearing commenced, the court was informed that AGL proposed to play no role in the proceeding. Solicitors appeared on behalf of Citipower and Powercor and informed the court that neither company would take part in the proceeding and would abide the event.
The sixth defendant, United Energy, appeared by counsel who, during the hearing on the first day, stated that it did not propose to play any part in the proceeding but maintain a presence in the court.
The court informed the representatives for the said four defendants that if any party wished to participate, it could apply to do so and that the question of participation was a matter for each defendant. As things transpired, the four defendants did not participate in the hearing.
The Nature and History of the Dispute
The basic facts which led to the dispute between the parties can be briefly summarised.
On 20 June 1995, the Governor in Council made an order, pursuant to the provisions of s.158A of the E.I Act, called the Victorian Electricity Supply Industry Tariff Order ("the Tariff Order") which regulated tariffs, charges and fees with respect to the supply of electricity in this State.
The Tariff Order, inter alia, prescribed the tariffs, charges and fees that could be charged by TXU and the other distributors for the distribution of electricity for the period from 1 January 1995 to 31 December 2000.
By reason of s.158(1)(a) of the E.I Act, the electricity industry became a regulated industry and the power to regulate prescribed prices with respect to the services was conferred on the Office in respect of, inter alia, charges for connection to, and the use of, any distribution systems – see s.158(1)(b).
Section 24 of the ORG Act provides –
"(1)The Office may regulate prescribed prices for or in respect of prescribed goods and services supplied by or within a regulated industry."
Section 25 of the same Act deals with price determinations. An important feature of the section is that the powers to determine the price set out in that section are, inter alia, subject to the "Order in Council under … s.158A of the E.I Act 1993" – see s.25(1).
This means that the provisions of the Order in Council, which established the Tariff Order, override anything contained in s.25 of the ORG Act.
In 1998, the Office commenced the process to determine the price that could be charged by the distributors from 1 January 2001. In so doing, it published consultative papers, reports and drafts, widely consulted on the process and had discussions with and considered submissions of, the distributors.
By determination made 21 September 2000, the Office determined the new charges which could be levied by the distributors for the use of their distribution systems for the period from 1 January 2001 until 31 December 2005.
The Tariff Order provided what was to be taken into account in determining the charges for the use of the distribution systems, and cl.5.10 set out matters that had to be taken into account. The opening part of the sub-clause provided -
"In making any price determination under s.25 or s.26 or both of the ORG Act regulating charges for use of Distribution Systems after 31 December 2000 the Regulator-General must, notwithstanding the criteria specified in the ORG Act or the Electricity Industry Act:
(a) utilise price based regulation adopting a CPI—X approach and not rate of return regulation."
The meaning and application of sub-cl.(a) were the main issues in this case.
It is noted that there were other sub-clauses of cl.5.10 that applied to the price fixing process as well as provisions of both the ORG Act and the E.I Act.
It was the opinion of TXU and three of the other four distributors that the Office had made a number of errors and accordingly, on 2 October 2000, these distributors instituted appeals pursuant to s.37 of the ORG Act to an Appeal Panel. The right to appeal is restricted by s.37(2) of the ORG Act. It is restricted to bias or where "the determination is based wholly or partly on an error of fact in a material respect." (Emphasis added.) Each distributor's appeal was a separate appeal, and dealt with as such.
The Appeal Panel held a hearing and senior counsel appeared on behalf of the distributors. One of the grounds of appeal raised by United Energy, which was adopted by all the distributors, was that in making the determination, the Office did not determine the charges on a price based regulation adopting a CPI—X approach but in fact adopted the prohibited rate of return regulation approach.
The Appeal Panel, comprising a lawyer and two eminent economists, rejected this ground of appeal but upheld some of the grounds of a factual nature. It delivered reasons on 30 October 2000. It affirmed the determinations in respect of the ground that the Office had failed to apply cl.5.10(a).
The Appeal Panel affirmed the determination in respect of the three grounds of appeal raised by TXU. I interpolate to observe that some of the other distributors were successful and the re‑determination amended the determination to give effect to the decisions. It is unnecessary to examine in detail the changes to the determination as a result of the Appeal Panel's findings except to note that the X factor fixed for the first year for TXU was reduced from 21.8% to 18.4%.
The complaint made to the court is that the Office made the determination and re‑determination without power. It was submitted that the Office had, contrary to the express terms of cl.5.10(a) of the Tariff Order, determined the charges adopting a rate of return regulation and not the method required by the Tariff Order.
Which determination?
The judicial review is in respect of the determination and the re-determination made by the Office. Mr J. Beach QC, who appeared with Mr P. Gray for the Office, submitted that the relevant determination was made by the Appeal Panel and not the Office because of the appeal and its outcome. It followed that TXU was out of court because the judicial review was in respect of the wrong decision and the Office was not the party who made the decision.
There is no doubt that this court has a supervisory jurisdiction to review a decision of a statutory body which affects the rights of, inter alia, bodies such as TXU and may quash the decision if the body acted, inter alia, without jurisdiction or power.
The determination made by the Office was open to challenge by appeal pursuant to s.37 of the ORG Act.
The right is limited to bias, which is not relevant here, and where "the determination is based wholly or partly on an error of fact in a material respect" – see s.37(2)(b).
Four distributors, including TXU, appealed the determination of the Office to the Appeal Panel.
One distributor, not TXU, took the ground of appeal that the Office had failed to comply with the provisions of cl.5.10(a) in determining the price. TXU and the other distributors adopted the ground of appeal and left it to the appellant to support the ground. The Appeal Panel considered the ground, held that it was not made out and affirmed the determination.
The Appeal Panel considered the three grounds raised by TXU, rejected them and affirmed the determination.
However, other distributors, Powercor and United Energy, succeeded in respect of some grounds, one of which had the effect of amending the X factor in relation to TXU. The formal decision of the Appeal Panel records that where grounds failed, "The Panel has decided to affirm the determination."
In respect of the grounds which were upheld, the formal decision records, "The Panel has decided that the determination be set aside and remitted to the Office for amendment to ensure" and directions were given as to what was to be done by the Office.
The ground raised before the Appeal Panel with respect to the construction and application of cl.5.10(a) of the Tariff Order to determining the price, raised a question of law and not fact and in my opinion, the Appeal Panel had no jurisdiction to entertain the ground of appeal. In any event, it was rejected and the Appeal Panel affirmed the determination in that respect.
Section 38(4)(b) of the ORG Act sets out the powers of the Appeal Panel with respect to the outcome of the appeal on errors of fact. It may affirm the determination, vary the determination to correct an error or set aside the determination "and remit it to the Office for amendment of the determination in accordance with the decision".
By reason of s.38(6), the Office is obliged to give effect to the decision of the Appeal Panel.
"Determination" is defined by s.3 as meaning "a determination made by the Office under this Act or any other Act."
The determination by the Office fixing a price for distribution of electricity was fixed pursuant to s.25 of the ORG Act.
Instead of rejecting grounds and affirming the determination and upholding grounds and setting aside the determination, the Appeal Panel should have, when it upheld a ground, set aside the determination with directions to amend it. It should not have both affirmed the determination and set it aside. If a ground of appeal is made out and the Appeal Panel decides to set aside the determination and remit it to the Office for amendment pursuant to s.38(4)(b)(iii), then the result is the determination is set aside. If it also rejects grounds of appeal, it is unnecessary and inappropriate to make a decision to affirm the determination. But in any event, it is clear what the Appeal Panel intended to do and that was that the determination be set aside and that it be remitted to the Office to be amended in accordance with the decision.
It follows that pursuant to s.38(6), which obliges the Office to give effect to the determination of the Appeal Panel, the decision which is binding and operative is the determination made by the Office giving effect to the decision of the Appeal Panel. It is that determination which binds TXU and the other distributors and which affects their rights.
The judicial review is in respect of the re-determination made 1 December 2000 by the Office of the Regulator‑General which is the proper party to the judicial review.
Judicial review jurisdiction
TXU is claiming relief in the nature of certiorari. In so doing, it is invoking the common law jurisdiction of this court to review the price fixing decision of the Office as a result of the re‑determination.
The jurisdiction is an ancient one and is subject to the procedural rules of the Court.
Order 56 is concerned with procedure. It abolishes the remedies in the nature of the old prerogative writs but nevertheless preserves the jurisdiction of the Court to make prerogative writ-type orders. It is clear the rules do not affect the common law jurisdiction of the Court, and it is equally clear that this Court has jurisdiction to make an order in the form similar to the old prerogative writ certiorari, namely, quashing the decision under review.
The old writ of certiorari went only to an inferior court or a body exercising powers pursuant to legal authority affecting rights of subjects. See R v Electricity Commissioners ex parte London Electricity Joint Committee Company (1924) 1 KB 179 at 205.
The present proceeding concerns the decision made by the Office, pursuant to statute, fixing the prices TXU could charge for the use of distribution systems after 31 December 2000 to supply electricity.
This proceeding is not concerned with the decision‑making process of an inferior court. In view of the distinction between jurisdictional error and non-jurisdictional error, it is important to note that the effect of a non-jurisdictional error of law by a body depends on whether it is a body or an inferior court making the decision.
But whether the decision is made by a body exercising legal authority or an inferior court, the jurisdiction is necessarily limited.
The jurisdiction is supervisory and does not entitle the court to canvass matters that it would on an appeal. The jurisdiction is a common law one and is different to an appeal.
The judicial review procedure is concerned with the legality of what was done by the body in question, and is not concerned with the merits of the decision under review. This is to be contrasted with an appeal, where the question usually is whether the decision is right or wrong, whereas the question on a judicial review is whether the decision is in accordance with the law.
The scope of the supervisory jurisdiction where the relief claimed is in the nature of the old writ of certiorari, namely, quashing the decision or order was summarised by the High Court in Craig v South Australia (1994) 184 CLR 163 at 175-76. In a joint judgment, the court said:
"Where available, certiorari is a process by which a superior court, in the exercise of original jurisdiction, supervises the acts of an inferior court or tribunal. It is not an appellate procedure enabling either a general review of the order or decision of the inferior court or tribunal, or a substitution of the order or decision which the superior court thinks should have been made. Where the writ runs, it merely enables the quashing of an impugned order or decision upon one or more of a number of distinct established grounds: most importantly, jurisdictional error, failure to observe some applicable requirement of procedural fairness, or fraud, and error of law on the face of the record. Where the writ is sought on the ground of jurisdictional error, breach of procedural fairness or fraud, the superior court entertaining an application for certiorari can, subject to applicable procedural and evidentiary rules, take account of any relevant material placed before it. In contrast, where relief is sought on the ground of error of law on the face of the record, the superior court is restricted to 'the record' of the inferior court or tribunal and the writ will enable the quashing of the impugned order or decision only on the ground that it is affected by some error of law which is disclosed by that record."
The jurisdiction is concerned with the decision‑making process. In Chief Constable of North Wales Police v Evans (1982) 1 WLR 1155, Lord Brightman at p.1173 said –
"Judicial review is concerned, not with the decision, but with the decision‑making process. Unless that restriction on the power of the court is observed, the court will in my view, under the guise of preventing the abuse of power, be itself guilty of usurping power."
It is not an appeal on the facts. In R v District Court; ex parte White (1966) 116 CLR 644, Windeyer J said at p.655 –
"I am not disposed to a narrow view of the scope of either certiorari or prohibition or of the power of this court to use these writs and also mandamus to ensure that administrative tribunals exercising functions under Commonwealth law proceed according to law and keep within the law. But we must not use these writs to give an appeal on the facts."
(Emphasis added).
The grounds upon which the review may be based, depend on whether the body in question is an inferior court or a body making a decision according to law.
In Craig's case, supra at p.176 the High Court said –
"In considering what constitutes 'jurisdictional error', it is necessary to distinguish between, on the one hand, the inferior courts which are amenable to certiorari and, on the other, those other tribunals exercising governmental powers which are also amenable to the writ."
The grounds available where the body is not a court were listed by Lord Reid in Anisminic Ltd v Foreign Compensation Commission (1969) 2 AC 147 at 171 –
"It may have given its decision in bad faith. It may have made a decision which it had no power to make. It may have failed in the course of the inquiry to comply with the requirements of natural justice. It may in perfect good faith have misconstrued the provisions giving it power to act so that it failed to deal with the question remitted to it and decided some question which was not remitted to it. It may have refused to take into account something which it was required to take into account. Or it may have based its decision on some other matter which, under the provision setting it up, it had no right to take into account. I do not intend this list to be exhaustive. But if it decides the question remitted to it for decision without committing any of these errors it is as much entitled to decide that question wrongly as it is to decide it rightly. … If it is entitled to enter on the inquiry and does not do any of those things which I have mentioned in the course of the proceedings, then its decision is equally valid whether it is right or wrong subject only to the power of the court in certain circumstances to correct an error of law."
(Emphases added).
The list is not exhaustive. The High Court in Craig's case has made it clear at p.178 that the principles stated by Lord Reid are confined to bodies other than a court of law.
The High Court at p.179 in Craig's case also listed the types of errors which may render a decision a nullity by a body lawfully exercising a decision‑making power –
"If such an administrative tribunal falls into an error of law which causes it to identify a wrong issue, to ask itself a wrong question, to ignore relevant material, to rely on irrelevant material or, at least in some circumstances, to make an erroneous finding or to reach a mistaken conclusion, and the tribunal's exercise or purported exercise of power is thereby affected, it exceeds its authority or powers. Such an error of law is jurisdictional error which will invalidate any order or decision of the tribunal which reflects it."
(Emphases added).
It is observed that the specified errors must result in the body's exercise or purported exercise of power exceeding its authority or powers.
In RSL v Liquor Licensing Commission (1999) 2 VR 203 at 210, Phillips JA after referring to what the High Court said, stated –
"The appellants' outline omitted altogether the critical expression 'and the tribunal's exercise or purported exercise of power is thereby affected' which plainly serves to qualify all the descriptions of error which precede it. Thus, to ask a wrong question, to ignore relevant material and so on, is jurisdictional error if – but only if – 'the tribunal's exercise or purported exercise of power is thereby affected'. … Ultimately, at all events when what is in question is error in the course of decision‑making … , the task for the court from which certiorari is sought must be to distinguish between, on the one hand, those matters which the tribunal is given the jurisdiction to decide, and even to decide wrongly (so that the error does not go to jurisdiction), and on the other hand those in respect of which, while it may have the power to enquire into them, it does not have the jurisdiction to decide wrongly (so that the error does go to jurisdiction)."
(Emphases added).
As is apparent from what His Honour said, the issue whether the error was one which affected jurisdiction was primarily one of construction of the instrument which gave the power or authority to the body to make the decision – see p.211.
At p.215 His Honour concluded –
"Accordingly, in a case like the present the essential search must be for the task which is confided to the body whose decisions are under attack; for only if that body strays beyond that task will there be a want or excess of jurisdiction."
(Emphasis added).
In my respectful opinion, that is the task which faces the court on a judicial review such as the present. It is clear from the limited nature of the jurisdiction that the court is not hearing an appeal and generally is not concerned with the merits of the decision. It is concerned with the decision‑making process. Did the decision‑making body make an error which showed that it did something which it did not have the power or authority to do?
This error may occur at the assumption of jurisdiction or may occur in the exercise of the jurisdiction, but what this court is concerned with at the outset is to consider and determine what power or authority was given to the body to make the decision, and having identified the alleged error, consider and determine whether the body's exercise or purported exercise of power was affected by the error which resulted in it exceeding its authority or powers. In other words, acting without jurisdiction.
Clearly, the Office had jurisdiction to make the determination which it did – see ss.24 and 25 of the ORG Act.
If error occurred, it occurred in the course of exercising that jurisdiction or authority. A body exercising statutory power may make an error in the course of exercising the power, and whether or not this court can quash the decision depends upon the nature of the error and whether it goes to jurisdiction. This necessarily involves considering what Parliament has entrusted the body to do.
As a general proposition, an administrative body lacks the authority to determine questions of law or to make a determination otherwise than in accordance with the law.
In Craig's case, supra, at p.179, the court said –
"At least in the absence of a contrary intent in the statute or other instrument which established it, an administrative tribunal lacks authority either to authoritatively determine questions of law or to make an order or decision otherwise than in accordance with the law.
That point was made by Lord Diplock in In Re Racal Communications Ltd:
'Parliament can, of course, if it so desires, confer upon administrative tribunals or authorities power to decide questions of law as well as questions of fact or of administrative policy; but this requires clear words, for the presumption is that where a decision making power is conferred on a tribunal or authority that is not a court of law, Parliament did not intend to do so'."
(Emphasis added).
See also RSL v Liquor Licensing Commission, supra, at p.214.
Of course, if the legislation did so authorise the tribunal to authoritatively determine questions of law or make a decision otherwise than in accordance with the law, judicial review would not be open if errors were made in respect of the law or the decision because the body would be acting within jurisdiction.
In the present matter, TXU asserts that in fixing the price regulating charges for the use of the distribution systems in the electricity industry, the Office acted without power in using a methodology which was not in accordance with cl.5.10(a) and which was prohibited by the sub-clause.
Privative Clause
From time to time, Parliament enacts a provision designed to oust or limit the common law supervisory jurisdiction of this court, which is known as a privative clause.
Section 40 of the ORG Act contains a form of privative clause. It provides –
"No proceedings may be brought in respect of a determination … other than on the grounds that there was no power to make the determination … or that the procedural requirements in relation to the making of the determination … have not been complied with."
(Emphasis added).
It is clear from s.41 of the same Act that Parliament anticipated that the provisions of the section would have an effect upon the jurisdiction of this court. For example, an error of law on the face of the record is not open.
This proceeding is not concerned with failure to comply with procedural requirements but is concerned with the power of the Office to make the determination which it did.
There is no warrant in the section or the Act to narrowly construe the words "there was no power to make the determination" and in my opinion, the reference to "power" covers not only a situation where the allegation is that the Office did not have the authority or power to embark upon the decision‑making process, but also covers the situation where it clearly has the power or authority to make the decision in question but did so without power in the exercise of it.
The contention put by TXU is that in the course of carrying out its authority to fix the price, the Office employed a method of doing so which was contrary to the Tariff Order and made without power.
It is unnecessary for the court to further consider the extent of the attempt by Parliament to reduce the jurisdiction of this court because TXU has asserted that the Office had no power to make the determination it did.
This court has jurisdiction to review the re-determination on the ground that in determining the price, the Office had no power to make the determination it did.
Purely question of fact – no review?
After TXU's counsel opened its case, Mr Beach QC objected to the admission into evidence of various affidavits filed on behalf of TXU. He submitted that the only evidence which was admissible was that contained in an affidavit by Patrick Ernest Murphy, which set out in summary form the circumstances of the determination and re‑determination and the appeals and exhibited the relevant documents. It was submitted that the other evidence was irrelevant.
In support of its case, TXU filed a number of affidavits. The evidence was from a number of eminent economists – Australian, English and American – and the affidavits addressed the questions of what the words meant in cl.5.10 of the Tariff Order, how they should have been applied by the Office in making the determination and finally, observations and comments about the determination and whether it was made without power.
The determination made by the Office is contained in two volumes. The first volume is concerned with a Statement of Purpose and Reasons and the second volume purports to be the actual Determination. Despite the fact that it is comprised in two volumes, in my opinion the Determination is in fact one determination comprising two volumes. This is so by reason of s.27(1) of the ORG Act which provides –
"A determination must include a statement of the purpose and reasons for the making of the determination."
I interpolate to observe that the Office had also filed affidavits which covered the same topics of evidence as the affidavits filed by TXU.
In the course of developing his submissions, Mr Beach QC submitted that the proceeding should be dismissed because the matters in dispute went to the merits of the determination made, were purely factual and it was clear that the task entrusted to the Office involved a question of fact and accordingly there could be no error of law.
In my opinion, it is clear that the meaning of the words used in cl.5.10 of the Tariff Order is a question of fact and accordingly, the affidavits were admissible on that ground in relation to that evidence. Whether the other two categories of evidence were admissible was debateable, and in the circumstances, I ruled that the affidavits be admitted into evidence subject to objection.
With respect to the question of this court having jurisdiction, Mr Beach referred to what Black CJ said in Australian Heritage Commission v Mt Isa Mines Ltd (1995) 60 FCR 456 at 466, where His Honour made it clear that questions of fact concerning the jurisdiction of an authority were usually a question for the authority alone to decide, especially in cases where there were complicated facts, assessments and value judgments to be considered and made. In my opinion, that is not the position here.
The question of the construction and application of cl.5.10 is a question of law for this court to decide. It is said by TXU that the Office misapplied the formula and accordingly made an error of law. Its final determination was made without power.
In my opinion, the main issue involved in this proceeding does involve a question of law.
Indeed, the issues raised in this proceeding are typical of issues raised in judicial review, namely, consideration by the court of the statutory power and authority of the administrative body to make a decision and whether in making the decision it acted within power. By way of example I refer to Pearlman v Keepers and Governors of Harrow School (1979) QB 56 and R v Hillingdon; ex parte Puhlhofer (1986) 1 AC 484.
Price Fixing – Legislative Framework
Clause 5.10 of the Tariff Order made 20 June 1995 sets out what is described in the heading as "Restrictions on review of price control arrangements made by the Regulator‑General" under, inter alia, s.25 of the ORG Act.
What that clause means and its application are questions of law which are to be determined by this court.
In order to determine the proper construction of the clause, it is necessary to set out the legislative scheme which authorised the Office to make the price determination.
The Office determined, for the five distributors in this State, the price each could charge for the use of their electricity distribution systems from 1 January 2001 until 31 December 2005.
Each distributor has a defined territory in which it operates its distribution system. TXU and Powercor operate in rural areas whereas the other three operate in Melbourne and its environs.
TXU operates in the area from the outer eastern suburbs to the eastern border of this State.
It is a trite observation that its distribution systems cover a larger area with fewer consumers than the urban distributors resulting in different financial considerations than those affecting the other distributors.
Under cl.4 of its licence, TXU is obliged to make its distribution network available to retailers and customers at a price which is consistent with the Tariff Order.
Clause 5.1.1 of the Tariff Order provides that a distributor must not charge a distribution customer more, for connection to and use of the distribution system, than the price approved by the Office for a financial year.
The Order was made on 20 June 1995 but commenced from 3 October 1994 – see cl.1.3.
The Tariff Order fixed the network tariffs for use of each distributor's distribution system for the financial year ending 30 June 1995. The distribution charges for the following financial years to 31 December 2000 were determined in accordance with the provisions of the Order. The prices were based on a CPI—X price cap method which was determined to give a rate of return on capital.
From 1 January 2001, the Office is responsible for regulating the prices and cl.5.10 describes a methodology that must be used, a prohibition on another form of regulation and also other matters that must be taken into account.
The legislative framework governing the Office's task is summarised as follows:
(i)The Office is authorised to regulate prescribed prices in respect of, inter alia, services supplied within a regulated industry – see s.24(1) of the ORG Act.
The electricity industry is a regulated industry – see s.158(1)(a) of the E.I Act.
Section 24(2) of the ORG Act defines "prescribed goods and services" and "prescribed price".(ii)Part 3 of the ORG Act deals with "Specific Powers" of the Office including price regulation and price determination.
By reason of s.158 of the E.I Act, power is conferred on the Office in respect of, inter alia, regulating charges for connection to and use of any distribution system. See s.158(1)(b)(ii).
(iii)Part 12 of the E.I Act is concerned with the regulation of the electricity industry, and is "relevant legislation" for the purposes of the ORG Act. See s.155 of the E.I Act.
This reference leads into the ORG Act. Provisions of Part 12 of the E.I Act have application with respect to the exercise by the Office of its various powers and authorities under the ORG Act. By way of example, s.4 of the ORG Act deals with interpretation and inconsistency between that Act and any other Act including "relevant legislation". See also ss.7(2), 8(a), 9(2), 24(2), 25 and 26 of the ORG Act.
(iv)Section 158A of the E.I Act gives power to the Governor in Council to regulate by order in such manner as it thinks fit, inter alia –
"(b)charges for connection to, and the use of, any distribution system."
Sub-section (1B) of s.158A provided –
"(1B) The Order may direct the Office to make a determination under the Office of the Regulator-General Act 1994 in respect of such factors and matters or in accordance with such procedures, matters or bases as are specified in the order, or both."
Sub-section (2) sets out a non-exhaustive list of matters that can be taken into account in specifying in the Order the manner in which prices are fixed.
(v)The Victorian Electricity Supply Industry Tariff Order was made by the Governor in Council on 20 June 1995 and was subsequently amended by orders made on 8 August 1995, 28 October 1997 and June 1998.
(vi)Section 25 deals with price determinations and pursuant to sub-section (2), wide power is given to the Office in making a price determination to regulate the prescribed price "in any manner the Office considers appropriate".
(vii)Section 25 is an important section and it is necessary to set it out in full.
"25. Price determinations
(1)This section is subject to anything to the contrary in the relevant legislation or Order in Council under section 3(2) or under section 158A of the Electricity Industry Act 1993 specifying the prescribed prices or prescribed goods and services in respect of which the Office is exercising its power of regulation.
(2)A price determination by the Office may regulate a prescribed price for prescribed goods and services in any manner the Office considers appropriate.
(3)Without limiting the generality of sub-section (2), the manner may include –
(a)fixing the price or the rate of increase or decrease in the price;
(b)fixing a maximum price or maximum rate of increase or minimum rate of decrease in the maximum price;
(c)fixing an average price for specified goods or services or an average rate of increase or decrease in the average price;
(d)specifying pricing policies or principles;
(e)specifying an amount determined by reference to a general price index, the cost of production, a rate of return on assets employed or any other specified factor;
(f)specifying an amount determined by reference to quantity, location, period or other specified factor relevant to the rate or supply of the goods or services.
(4)In making a determination under this section, the Office must have regard to –
(a)the costs of making, producing or supplying the goods or services;
(b)the return on assets in the regulated industry;
(c)any relevant interstate and international benchmarks for prices, costs and return on assets in comparable industries;
(d)the financial implications of the determination;
(e)any factors specified in the relevant legislation;
(f)any other factors that the Office considers relevant."
(Emphases added).
(viii) It is important to emphasise a number of features of s.25.
First, the section is subject to anything to the contrary in the Tariff Order.
By reason of s.18 of the Interpretation of Legislation Act 1984, the reference to the Order in Council is to be construed as a reference contained in a subordinate instrument made pursuant to the provisions of the Act in which the reference occurs.
As a general proposition, subordinate legislation cannot override, amend or alter a statute. Parliament is the source of the authority to make the subordinate instrument and it follows that it cannot affect an Act of Parliament. But Parliament can confer the power – see Hall v Paparua County Council (1976) 2 NZLR 350 at 352 and Williams v Volta (1982) VR 739 at 747.
Parliament has given power to the Governor in Council to give the Tariff Order precedence over anything contained in s.25 of the ORG Act. But it is important to emphasise that the section does not provide for the Order in Council to override any other provision of either the ORG Act or the E.I Act.
The second matter to observe is sub-section (3), in a non-exhaustive list, sets out the methods by which the office may prescribe the price.
The third matter is that under sub-section (4), the Office is obliged to take into account certain specified matters which includes factors specified in the E.I Act and also any other factors the Office considers relevant. However, consistent with the direction in sub-section (1), the provisions of the Order in Council would override the obligations imposed on the office by sub-section (4) if the Order in Council addressed the particular matter; in other words, if the provision of the Tariff Order was contrary to any matter referred to in s.25(4).
(ix)Section 35 of the Interpretation of Legislation Act 1984 requires the court, in interpreting a provision of an Act or subordinate instrument, to adopt a construction that would promote the purpose or object underlying the Act or subordinate instrument, and in seeking the purpose or object, consideration may be given to certain extrinsic material. Both the E.I Act and the ORG Act expressly enumerate the objectives and purposes of the Office and the legislation.
(x) Section 157 of the E.I Act sets out the objectives of the Office.
The section provides –
"157. Objectives of the Office
The objectives of the Office under this Act are –
(a)to promote competition in the generation, supply and sale of electricity;
(b)to ensure the maintenance of an efficient and economic system for the generation, transmission, distribution, supply and sale of electricity;
(c)to protect the interest of consumers with respect to electricity prices and the safety, reliability and quality of electricity supply;
(d)to facilitate the maintenance of a financially viable electricity supply industry."
Matters which are clearly relevant and of substance in price determination are the necessity to maintain an efficient and economic system for distribution, the protection of consumers with respect to, inter alia, reliability and quality of electricity supply and the importance of maintaining a financially viable electricity supply industry.
Whilst it is very much in the interests of the consumer to keep the prices down, it is equally important in the interests of consumers and distributors of electricity that the latter are able to continue in business. Given the choice, the consumer would prefer electricity at a price than no electricity at all.
(xi)Section 1(b) of the ORG Act states the purpose of the Act, which was to establish the Office and create an economic regulatory framework for, inter alia, the electricity industry "which promotes the simulation of competitive market conduct and the prevention of the misuse of monopoly power" in the absence of a competitive market.
(xii)Section 7 is concerned with the objectives of the Office and provides –
"7. Objectives of the Office
(1)In performing its functions and exercising its powers the Office has the following objectives –
(a)to promote competitive market conduct;
(b)to prevent misuse of monopoly or market power;
(c)to facilitate entry into the relevant market;
(d)to facilitate efficiency in regulated industries;
(e)to ensure that users and consumers benefit from competition and efficiency.
(2)Without derogating from sub-section (1), the Office must also perform its function and exercise its powers in such a manner as the Office considers best achieves any objectives specified in the relevant legislation under which a regulated industry operates."
(xiii)Section 9 deals with the powers of the Office and provides –
"9. Powers of the Office
(1)Subject to this Act, the Office has power to do all things necessary or convenient to be done for or in connection with the performance of its functions and to enable it to achieve its objectives.
(2)Without derogating from sub-section (1), the Office also has such powers as may be conferred on the Office by the relevant legislation under which a regulated industry operates."
(xiv)The Tariff Order is a long, detailed and complicated document comprising 92 pages together with 43 pages of attachments. Attachment 1 contains definitions and attachment 2 is concerned with rules of interpretation. The latter is concerned more with definitions rather than any rules of interpretation.
Clause 5 is concerned with the network tariffs which can be charged by a distributor. It is divided into a number of sub-clauses which cover a variety of topics. Clauses 5.1 to 5.8 ceased to have effect on the later of 31 December 2000 or by the making by the Office of a price determination under, inter alia, s.25 of the ORG Act for use of distribution systems - see cl.5.9.1. That leaves the only other sub-clause in cl.5, which is sub-clause 10. It is necessary to set out the sub-clause in full.
"5.10Restrictions on review of price control arrangements by the Regulator-General
In making any price determination under section 25 or section 26 or both of the ORG Act regulating charges for use of Distribution Systems after 31 December 2000 the Regulator‑General must, notwithstanding the criteria specified in the ORG Act or the E.I Act:
(a)utilise price based regulation adopting a CPI—X approach and not rate of return regulation;
(b)where the value of the fixed assets which were allocated to a Distributor under the allocation statements under Sections 117 and 137 of the E.I Act is required to be taken into account, use the adjusted asset value for that Distributor as at 1 July 1994 determined in accordance with the table set out below, adjusted to take into account inflation and depreciation on the asset value increased by inflation since 1 July 1994 and for any disposals since 1 July 1994:
TABLE
Eastern
$m
Powercor
$m
Solaris
$m
CitiPower
$m
United
$m
Optimised Depreciated Replacement Cost
1,046
1,227
361
482
743
Adjustment
(218)
(161)
61
129
136
Adjusted asset value (opening book value)
828
1,066
422
611
879
(c)take into account the value of K calculated for each Distributor in accordance with clause 5.3.5 and 5.5.5 for the Financial Year ending 30 June 2001;
(d)have regard to the need to:
(i)provide each Distributor with incentives to operate efficiently;
(ii)ensure a fair sharing of the benefits achieved through efficiency gains between customers and the Distributors;
(iii)ensure appropriate incentives for capital expenditure and maintenance in the Distributor's Distribution Systems; and
(iv)have regard to the level of executive remuneration in each Distributor by reference to any relevant interstate and international benchmarks for such remuneration; and
(e)subject to clause 6.3, set the price controls for use of Distribution Systems and Network Tariffs (if any) for a period of not less than 5 years."
Clause 6.3 permits the re-opening of the price determination during the period set under 5.10(e), but only in a limited way. The price may be re-opened if it was set on the basis of information provided by a licensed person and the information was false or misleading. Or, where there was a material error in the price determination, the Office may revoke the price, but only with the prior written consent of the licensed person affected by the determination. Or, the licensed person applies on the basis that the determination is materially adversely affected as a result "of an event beyond the licensed person's control which was not contemplated at the time the price determination was made", but then on certain terms and only with the prior written consent of all licensed persons to which the price determination applies.
It is appropriate to make a number of observations concerning cl.5.10.
First, the real issue in the present proceeding focuses on the words used in cl.5.10(a). It is the contention of TXU that the Office made the price determination not in accordance with the mandated formula, using rate of return regulation which was prohibited.
Hence, the determination was made without power.
Secondly, it is observed that the Office "must notwithstanding the criteria specified in the ORG Act or the E.I Act", adopt a certain approach. What criteria in the said two Acts are overridden by the sub-clause?
Thirdly, whether or not the values of fixed assets are required to be taken into account clearly is a matter for the Office and will depend upon the Office's methodology, but if used, then they must be used in accordance with the table.
Fourthly, the Office is required to have regard to the specified factors set out in paragraph (d)(i)-(iv) (inclusive).
Finally, by reason of s.25, the Order overrides anything that is in s.25 which is inconsistent with it.
Task Entrusted to Office
The Office made a price determination pursuant to s.24 of the ORG Act. Its authority and powers are found in the Order and the two pieces of legislation.
The Office was required, pursuant to cl.5.10(a), to adopt a certain methodology in regulating the charges and was prohibited from adopting another methodology.
The word "formula" has a variety of meanings. One definition is "a procedure to be followed", and I propose to refer to the required methodology as the mandated formula and the prohibited regulation as the prohibited formula.
The evidence established that the mandated formula is imprecise, uncertain and of recent origin. On no view could it be described as a mathematical or scientific formula. It is a formula which sets out to achieve certain objectives.
The prohibited formula also seeks to achieve certain objectives but is a formula which has been used in excess of 100 years, and has certain well accepted characteristics.
The framers of the Tariff Order did not define either formula. That is despite the fact that there are a large number of detailed definitions and interpretation directions included in the attachments. The failure to define either formula shows an intention on the part of the framers of the Tariff Order to leave to the Office the decision as to methodology, and how the price fixing exercise was to be performed within the meaning of the Tariff Order and legislation.
The formula "price based regulation adopting a CPI−X approach" is not found in any of the economics literature prior to the making of the Order on 20 June 1995. On the other hand, methods of price fixing based upon price as distinct from cost have been used for some 60 or 70 years, mainly in the United States of America. A common form of price based approach is what is called a price cap method of price fixing. It is the contention of the Office that the terms "price based regulation" and "price cap" approach are synonymous. This is disputed by TXU.
The approach known as CPI—X is a concept taken up and developed by Professor Stephen Littlechild who, during the 1980s and for most of the 1990s, was responsible for fixing prices for privatised industries in England. He applied the English equivalent to CPI—X, namely, RPI—X. Again the evidence established that it was a method which set out to achieve certain objectives which were markedly different to the objectives applying to the rate of return regulation. The concept has been in a state of evolution over the last 15 years..
The Office made the price determination under ss.24 and 25 of the ORG Act. In making the Determination, the Office was obliged to comply with the provisions of cl.5.10 of the Tariff Order.
This raises the questions of what is meant by the provisions of cl.5.10, in particular cl.5.10(a), and how they were to be applied by the Office.
The object of construing a statutory provision is to determine what the intention was, of the framers of the statutory instrument at the time it was enacted or made.
The primary source of the intention is the words of the provision, construed in their normal and natural meaning, subject to any definition and context and after reading the instrument as a whole.
If the words are precise and certain, and there is no debate as to their application to the facts, then the court is bound to construe the words in their ordinary and natural sense. The words themselves best declare the intention of those responsible for their enactment. See Cargo Ex Argos (1872) LR 5 PC 134 at 153.
Rarely, in contested litigation these days, can that approach be adopted. Adversarial minds have little difficulty in creating a difference of opinion as to the meaning and application of words in a statutory instrument.
Often, the court must go wider than confining the construction to the four corners of the instrument.
In 1877, Lord Blackburn expressed the approach in an oft cited dictum when he said in The River Wear Commissioners v William Adamson (1877) 2 App Cas 743 at 763 –
"I shall therefore state, as precisely as I can, what I understand from the decided cases to be the principles on which the courts of law act in construing instruments in writing; and a statute is an instrument in writing. In all cases the object is to see what is the intention expressed by the words used. But, from the imperfection of language, it is impossible to know what that intention is without enquiring further, and seeing what the circumstances were with reference to which the words were used, and what was the object, appearing from those circumstances, which the person using them had in view; for the meaning of words varies according to the circumstances with respect to which they were used."
A court is permitted, where the statutory instrument is uncertain in meaning or application, to consider the scope, purpose and object of the legislation. The court is permitted to consider the history surrounding the enactment. The court is also permitted to put itself in the shoes of the authors and take into account what the authors knew concerning the subject matter of the proposed instrument.
In R v West Riding County Council (1906) 22 TLR 783, Farwell LJ said –
"The court must, of course, in construing an Act of Parliament, as in construing a deed or will, do its best to put itself in the position of the authors of the words to be interpreted at the time when such words were written or otherwise became effectual."
Today, legislation requires the court to construe a subordinate instrument in a manner which promotes the purpose or object underlying the statutory instrument. Such construction is preferred to a construction which would not promote the purpose or object. See s.35 Interpretation of Legislation Act 1984. In construing a provision, consideration may be given to a variety of extrinsic materials provided the material in question is relevant. See s.35(b).
The permitted extrinsic material is any matter or document, and the only limitation is that it is relevant to the interpretation.
In my opinion, Parliament intended that the court should consider all extrinsic material which may assist it in determining the intention of the framers of the statutory instrument. The important considerations are relevance and care in weighing the extrinsic material.
However, as has been pointed out by the High Court in a number of recent cases, the words in the statute are the primary source of the intention, and if they are precise and unambiguous, they best declare the intention of the body responsible for the statutory instrument. See Re Bolton; ex parte Beane (1987) 162 CLR 514 at 518 and Walker v In Line Couriers Pty Ltd (1999) 73 ALJR 1084 at 1085.
The parties did rely upon extrinsic material.
The task entrusted to the court in construing a statutory instrument is two-fold, namely, what is the meaning of the words used and what is their legal effect?
The meaning of the words is a question of fact. The legal effect is a question of law. In Chatenay v Brazilian Submarine Telegraph Co (1891) 1 QB 79 at 85, Lindley LJ said –
"It is well at the outset to guard against confusion between the meaning and the legal effect of expressions used in a statute. The expression 'construction' as applied to a document, at all events as used by English lawyers, includes two things – first, the meaning of the word; and secondly, the effect which is to be given to them. The meaning of words I take to be a question of fact in all cases, whether we are dealing with a poem or a legal document. The effect of the words is a question of law."
Sometimes words used in a statutory instrument are technical words, and the court requires the assistance of evidence to determine what the words mean. The words found in cl.5.10(a) are technical words, which no doubt have meaning to those involved in the price regulation industry and in particular economists, but mean nothing to the layman. They are technical words understood in a particular field, and must be given a meaning according to their usage in that field.
The approach to the construction of a provision of a statutory instrument which contains a technical term was stated by O'Connor J in Markell v Wollaston (1906) 4 CLR 141 at 150 –
"The general rule of interpretation is that words used in a statute must be taken to have been used in their ordinary meaning. If it is contended that there is a commercial or other special meaning of the word, there must be evidence before the court on which it can come to the conclusion that the word is so used, and then it is for the court to determine whether the legislature has used the word in its ordinary signification or in the special sense."
Where terms of art are used, evidence may be given as to what the words mean. The court is permitted to refer to books which show what the words mean.
In Borowski v Quayle (1966) VR 382 at 385, Gowans J stated the principles as follows –
"The term 'antibiotic substance' is a technical one. But a court cannot treat such a term in a statute as having no meaning for it. If not assisted by evidence it may itself have resort to technical dictionaries of authority. … But in the absence of such aid evidence may be given as to the meaning and denotation of the technical term."
In London and North NE Railway Co v Berriman (1946) AC 278 at 294 Lord MacMillan said –
"I recognise that when Parliament employs technical terms without definition in a statute dealing with a particular art or industry, courts of law are entitled to have the assistance of skilled persons in the interpretation of such terms. Indeed the present statute and rules contain numerous technical terms as to whose meaning in railway parlance evidence would be almost indispensable."
In the same case at p.310 Lord Simonds said –
"It is only by reference to the industry that the meaning can be ascertained … It remains a question of evidence what the words mean in the industry. They are a term of art and it is by those skilled in the art that I must be instructed."
(Emphasis added).
The two formulae contained in cl.5.10(a) of the Tariff Order comprise words which may be terms of art. The art is the regulation of prices of public utilities. The experts in that area, price regulators and economists, are skilled in that art and their evidence is admissible to enable the court to give legal effect to the terms of the Tariff Order.
Parker LJ summarised the principles in R v Patents Appeal Tribunal; ex parte Baldwin and Francis Ltd (1959) 1 QB 105 at 111 when he said –
"Thus, when the language of the instrument is such that the court does not understand, it is competent to receive evidence of the proper meaning of that language, and this is so whether it is written (for instance) in a foreign tongue or contains technical terms of science or art."
When a word or phrase is described as a term of art, usually it is not difficult for the court by reference to a book, such as a dictionary of technical terms or a textbook, to determine what the word or phrase means. The industry, profession or field of learning evolve their own language to define a word or phrase. They acquire a well accepted meaning. The lexicon of the terms of art is found usually in a dictionary or a textbook. There is usually no debate as to meaning. However, that is not the case here. Witnesses were called on both sides as to the meaning of the formulae contained in cl.5.10(a), but on any view of the evidence, there is a degree of uncertainty as to what each formula means.
In my opinion, the evidence of the experts called by TXU and the Office as to what the words mean, is admissible.
What do the words mean – clause 5.10(a)?
Clause 5.10(a) provides "(a) Utilise price based regulation adopting a CPI—X approach and not rate of return regulation".
It is convenient to divide up the sub-clause to determine what the words mean. However, in determining their application, which is a question of law, the sub-clause will have to be construed as a whole and in context and after taking into account the relevant provisions of both the ORG Act and the E.I Act.
"Price based regulation"
When reference is made to the art, namely, price regulation and economics, we find that the phrase "price based regulation" is not a term of art, and is a phrase which has been rarely used prior to the date of the Tariff Order, 20 June 1995, and did not at that date have a definite meaning.
The eminent economists called by each side addressed the question of what cl.5.10(a) meant. In giving their evidence, each made extensive use of articles and textbooks concerning price regulation in relation to public utilities.
In addition, an economist called by the Office, Gregory John Houston, who has had extensive experience in the regulatory review of tariffs for various electricity, gas, water, rail, airports and telecommunications utilities since 1989, carried out a survey of the relevant literature in the field of price regulation and economics. He reviewed some 69 articles and texts by 59 authors.
The evidence revealed that the phrase "price based regulation" was not a term of art. Prior to 1995, it had been used in two articles. Two economists in 1989, in an article, had used the phrase to describe a concept concerning price regulation. In another article in 1993, an economist also used the phrase.
By 20 June 1995, it could not be said that the phrase was a term of art which had an accepted meaning amongst price regulators and economists. It was a phrase coined by two economists in 1989 to describe a price fixing approach.
The experts called by each side gave evidence as to what they understood the phrase meant, and in so doing, were very much influenced by the provisions of cl.5.10(a). In so far as the experts gave evidence as to what they thought the phrase meant in the context of the clause, in my opinion, the evidence is irrelevant. Evidence may be given as to what words mean within a particular area of learning, but their effect and application in the statutory instrument is a question of law.
Evidence from Professor King, Professor of Economics at the University of Melbourne, on behalf of TXU, was that there were two articles in 1982 and 1989 which contained formulae which utilised what he described as "price based regulation". However, the articles did not support what he said, but appeared in a general way to support his theory as to what the phrase "price based regulation adopting CPI—X approach" meant.
What is clear is, that by 20 June 1995, two articles had referred to the phrase and the information was available to the framers of the Tariff Order at the relevant time.
According to the evidence, the phrase first appeared in an article in the prestigious "Rand Journal of Economics" by Messrs Braeutigam and Panzar of the North Western University, United States of America. The article appeared in the autumn edition 1989.
In the first two pages of their article, the authors referred to a regulatory process and having described that regulatory process, stated that it was a "cost based regulation".
They went on to summarise the deficiencies of what they described as a rate of return or cost based regulation as follows on p.374 –
"A lengthy literature has developed on the potential economic inefficiencies that might accompany either rate-of-return regulation or fully distributed cost pricing, even when diversification into competitive markets is not an issue. Some of the resulting inefficiencies include the failure of the firm to minimise its costs in producing any observed output, the inability of the regulatory regime to force the firm to operate in an inelastic region of demand, the lack of incentives for the firm to develop socially desirable cost-reducing innovations, and the incentive for the firm to engage in inefficient diversification into competitive markets."
These deficiencies were accepted by the experts on both sides in the present proceeding as the real problems of a price fixed by rate of return regulation.
The authors then went on to say at p.375 –
"As an alternate to cost-based regulation, there is currently great interest in a form of regulation that would establish rate caps on non‑competitive services and allow the firm to enter into competitive markets, charging whatever prices it likes. We refer to this as 'price‑based' regulation. In its simplest form, the firm is regulated by rate caps determined exogenously for the non-competitive markets. Thus, the firm will find it profitable to produce its output in cost‑minimising fashion, to innovate when it is socially desirable to do so, and to diversify into competitive markets only if it is economically efficient to do so."
(Emphasis added).
The authors then went on to say –
"A model of the firm operating under price-based (price-capped) regulation is presented and analysed in section 4."
(Emphasis added).
It is clear from the article that the authors used the phrase "price based regulation" and "price cap regulation" interchangeably. This provides support for the Office's opinion to the same effect.
In an article in the "Journal of Regulatory Economics" in 1993 by Dennis Weisman of Kansas State University called "Superior Regulatory Regimes in Theory and Practice", the author states in his Introduction the following –
"A substantial body of recent research examines the superiority of price‑based or price-cap over cost-regulation."
In his footnote at the bottom of p.355, the author says –
"We use the terms price-based and price-capped regulation interchangeably. The latter term has come into vogue in the telecommunications industry due to recent experiments with capping prices by British Telecom and the Federal Communications Commission. See Beesley and Littlechild (1989)."
That was the state of the information available, as at 20 June 1995, according to the evidence. That is what the evidence reveals is the meaning of the words used in the phrase, namely, a form of price-cap regulation.
Writing in an introduction to a symposium of price cap regulation published in The Rand Journal of Economics, Vol. 20, No. 3 in 1989, Messrs Acton and Vogelsang, from the Rand Corporation and Boston University respectively, said at p.370 –
"What do we mean by price caps? As is well known from the history of rate-of-return regulation, a sharp characterisation of a regulatory mechanism is not easy. The two best known characterisations of rate‑of‑return regulation by Averch and Johnson (1962) and Joskow (1972 and 1974) are very different from one another. Both appear to be fruitful because they allow for a more diversified discussion of arising issues. Keeping this in mind, we aim for a definition of price‑cap regulation that is compatible with the articles in this symposium and with our research and practice. In our view, price caps are characterised by four properties:
1. The regulator director sets a ceiling for prices to be charged by the regulated firm. The firm may chose the prices below the ceiling
2. Price ceilings are defined for baskets of services offered by the regulated firm. They can be expressed as price indices for these baskets – and different ceilings may apply for each basket.
3. These price indices are adjusted periodically by a pre‑announced adjustment factor that is exogenous to the regulated firm.
4. In longer intervals of several years, the adjustment factors, baskets and weighting schemes for the indices are reviewed and possibly changed.
While appearing to be a British import, price caps are not new to Americans."
(Emphasis added).
The learned authors go on then to note that many claims "have been made about price caps and their superiority over rate of return regulation". The authors emphasised the uncertainty amongst economists as to the characteristics of the various price fixing formulae that have been used.
The above references were available to the framers of the Tariff Order when they considered what method was to be used to fix the price for distribution of electricity.
"Adopting a CPI—X approach"
"CPI—X approach" is that part of the mandated formula that deals with the adjustment of the prices each year. CPI is a well-known concept in Australia, and by reference to the publication by the Australian Bureau of Statistics, one can determine the movement in the cost of living for a particular period. The X is fixed as part of the adjustment mechanism.
As already stated, in the original Determination, the X factor for TXU for the first year, 2001, was 21.8% which, after the Appeal Panel hearing and re‑determination, was reduced to 18.4%.
The X factor for TXU and the other distributors for the years 2002-2005 was 1%.
The X factors for the other distributors for 2001, after re-determination, were: AGL, 15.5%; Citipower, 11.2%; Powercor, 14.5%; and United Energy, 9.1%. It can be seen that the X factor, after re-determination, was the greatest for TXU.
The words under consideration are "adopting CPI—X approach". It is noted that the phrase is not "CPI—X regulation", which is a form of price fixing regulation used in the United Kingdom; a method which was a form of price cap regulation.
The witnesses, when discussing the phrase, discussed it in the context of a mechanism used for price fixing for public utilities in the UK.
The present issue is concerned with what the words mean, whereas the ultimate issues are, what does the mandated formula mean and how was it to be applied by the Office?
TXU's counsel submitted that "CPI—X approach" does not mean "CPI—X regulation". That submission will have to be considered later when determining what was the intention of the framers with respect to the application of the mandated formula. At present, I am concerned with what the words mean.
The witnesses called by both sides gave evidence with respect to meaning, based upon the way the RPI—X formula was used in the UK.
By way of example, Professor Littlechild said –
"A 'CPI—X approach' takes its name from RPI—X, first used as such in the United Kingdom in 1983."
The Professor explained what he meant, and then went on to say –
"Adopting a 'CPI—X approach' means, broadly, using a method of regulation whereby X is set so as to increase (or at the very least acknowledge the importance of) incentives on the regulated company, and possibly on other players in the industry."
In his evidence, Professor Littlechild tended to use the phrases CPI—X regulation and CPI—X approach interchangeably.
The CPI—X regulation was first formulated in the early 1980s in the United Kingdom, and was adopted and applied by Professor Littlechild in his capacity as a regulator in the United Kingdom. As a concept, it has a well established meaning in the economics literature and could be described as a term of art. In its pure form, it is an adjustment procedure that permits prices to be adjusted periodically by CPI less the X factor.
According to this approach, the price set by the regulator is increased by the general rate of inflation, measured by the CPI, less an adjustment factor X each year. The X is usually fixed for certain periods over a number of years.
As a general proposition, the X factor is a predetermined figure that reflects forecast changes in industry demand, costs and underlying industry efficiency. The Regulator sets the X factor in advance, and in this instance, it was for five years, as was required, as a minimum, by cl.6.3 of the Tariff Order.
I reiterate that in seeking to determine what is meant by the phrase "adopting CPI—X approach", it is important to bear in mind the context. The evidence demonstrated that a concept of "CPI—X regulation" is a method of price fixing. It has certain characteristics when used as a price regulation method. On the other hand, in context, the phrase "adopting CPI—X approach" is the part of the formula used as an adjustment mechanism to the prices each year.
Criticism was made by TXU that the Office did not distinguish between "CPI—X approach" and "CPI—X regulation". It is clear that throughout the Determination and the Reasons, the Office has used the phrases interchangeably, and it was submitted by TXU that that demonstrates error. It will be necessary to consider this later when considering the legal effect of cl.5.10(a) and its application.
CPI—X regulation as a price fixing method had been used by Professor Littlechild in regulating the electricity industry in England in 1990 and later years. It was described as a price cap method of price fixing.
Before considering his evidence, it is necessary to observe that a price cap CPI—X regulation is an incentive based method for regulating prices.
Under a price incentive regulation, the regulated firm is rewarded for its efforts in directly improving its profit over a fixed period, usually of some length, and the regulator does not attempt on the review to pass the profits made back to the consumer. In other words, the firm is entitled to reap the benefit of its efficiency in reducing prices and increasing its profits.
Professor Littlechild gave evidence that the method was a much bigger and broader concept than rate of return because it had not been honed by 100 years of practice. He stated that "there are different kinds of a CPI—X approach, and it is quite possible to want to refer to some of those and not to others."
The CPI—X regulation was developed in the United Kingdom specifically for the task of privatising industries, but on any view, was in a state of evolution in 1995. As will become apparent, the methodology has certain characteristics which distinguish it from rate of return regulation.
Professor Littlechild gave the following evidence –
"A CPI—X approach takes its name from RPI—X, first used as such in the United Kingdom in 1983. RPI—X or CPI—X requires the use of a price control that allows a regulated company's prices (or revenues) to increase in line with the rate of inflation minus a specified number, 'X'. If, for example, X were three, this would mean that (maximum) prices should fall in real terms (relative to inflation) by 3% a year.
Adopting a CPI—X approach means, broadly, using a method of regulation whereby X is set so as to increase (or at the very least acknowledge the importance of) incentives on the regulated company, and possibly on other players in the industry. These would typically be incentives to reduce costs, to increase output, to improve quality of service or to innovate, and in certain contexts, might embody incentives to others to enter the market. …
The set of processes or calculations that would fall under the definition of a CPI—X approach is broader and less well defined than the traditional concept of rate of return. It is a more recent concept, and is developing in response to new challenges and lessons of experience."
(Emphasis added).
The concept of CPI—X is in a state of evolution, and although the economics literature on regulating prices contain many discussions seeking to explain and investigate the X factor, very little guidance is given by the economic literature as to how one goes about setting X. Mr Ergas, an economist called by the Office, noted that there was a notable exception to that observation, in that an article written by Messrs Bernstein and Sappington in 1998 stated the following basic rule as at 1998, namely –
"The X factor should reflect the extent to which the regulated industry has historically achieved higher productivity growth and faced lower input price inflation than other industries in the economy."
(a)Establishing forward looking cost or expenditure benchmarks for each of the distributors for operating expenditure, capital expenditure and cost of capital;
(b)establishing an amount for depreciation;
(c)determining an additional allowance called the efficiency carry over amount for operating and capital costs savings achieved by the distributors in the first period;
(d)establishing a benchmark revenue comprising the amounts derived in accordance with the steps (a) to (c) above, which is known as the building blocks approach;
(e)establishing demand projections for each distributor for the period 1 January 2001 to 31 December 2005;
(f)modelling the X factors to produce a price path for the basket of Network Tariffs whereby an efficient distributor, based on the demand projections, can be expected to earn the benchmark revenue.
He also gave evidence of the effect. The effect of the exercise was that the price determination regulated prices, and not rates of return or revenues, which meant that if the distributor was able to derive greater revenues than those set out in the benchmark revenues, it was entitled to reap the benefit. The CPI—X price cap applied to prices and did not cap the returns or revenue of the distributors. Further, the price determination applied for five years and could not be amended or reviewed during the course of the regulatory period, and only in limited circumstances provided by cl.6.3 of the order. The price determination reflected forecast of demand and expenditure benchmarks such that the distributor bears the risk and obtains a reward from any variance between the forecasts and actual performance. Further, and importantly, there could be no adjustment made to the X factors in the event that the financial performance of a distributor exceeded or fell short of the assumptions used to establish the X factor. In addition, the X factor incorporated an additional allowance for efficiency gains achieved by a distributor in the period from 1995 to 2000, being the efficiency carry over amount and, as a consequence of that carry over amount, the returns to a distributor by reason of the X factors are higher than the weighted average cost of capital, that is, the notional rate of return to debt and equity holders in the distributor.
Mr Wilson gave evidence that the Office gave effect to and complied with the other provisions of cl.5.10, namely, 5.10(b), (c) and (d).
His evidence was that the Office set the tariffs pursuant to the mandated formula, and did not set a price over the regulatory period that was an allowable rate of return, nor did it determine the specific operating costs of a particular distributor.
I accept Mr Wilson's evidence. It supports the conclusion that the Office utilised a price based regulation adopting a CPI—X approach methodology to the determination. On any view, his evidence provides a substantial obstacle to the contention of TXU that the price determination was made without power.
I now turn to the Determination itself and, in particular, the Reasons and the specific complaints made by TXU.
The Statement of Purpose and Reasons, being Volume 1 of the Determination, is a very long and detailed document which covers many topics including expenditure on distribution services, efficiency carry over, cost of capital financing and the X factors.
It is appropriate to deal with each of TXU's complaints.
· Having regard to the specific costs of each distributor
The gravamen of this complaint is that the Office had regard to the specific financial position of each distributor, and in particular regard to specific costs. This is something invariably done in rate of return regulation.
First, there is nothing in the Tariff Order or the legislation which precludes the Office from considering the question of the specific costs of each distributor. That hardly meets the contention of TXU which is, that such an approach is not the mandated formula method but, in fact, is classical rate of return regulation. Nevertheless, it is noted that there is no prohibition on considering the distributor's specific costs.
Secondly, the mere fact that the distributor's specific costs are considered in applying the mandated formula, does not mean that the price determination is the result of rate of return methodology. There is no doubt that in carrying out a rate of return regulation exercise, the distributor's financial position forms the basis of the determination and, in particular, its costs, likely future costs and the necessary amount of revenue to cover the cost. That is the basis of rate of return regulation but there mere fact that consideration is given to the same matters in applying another price regulation approach does not convert that approach into rate of return. There has to be something more.
Thirdly, cl.5.10(a) cannot be construed and applied in a vacuum.
It is clear from cl.5.10(b) that in the methodology adopted by the Office, use could be made of the value of the fixed assets allocated to a distributor and if so, must take into account the values in accordance with the table. More importantly, in relation to giving effect to cl.5.10(d), that is, having regard to the need to provide each distributor with incentives to operate efficiently to ensure a fair sharing of benefits achieved through efficiency gains, and to ensure appropriate incentives for capital expenditure and maintenance in the distributor's distribution system, the Office would of necessity have to consider the financial position of each distributor. Further, under s.25(4)(a) of the ORG Act, the Office was obliged to have regard to the costs of making, producing or supplying the services, and this would involve looking at the particular distributor's costs. Finally, giving effect to s.157 of the E.I Act, which is to ensure the maintenance of an efficient and economic system for the distribution of electricity would also, in my view, oblige the Office to consider the financial position of each distributor and, in particular, the specific costs of each distributor. It is noted under s.7(2) of the ORG Act, the Office must perform its functions and exercise its powers to achieve the objectives specified in the E.I Act.
Finally, I accept the evidence of Mr Wilson that the Office did not set a price over the regulatory period such that there was an allowable rate of return, and did not attempt to determine the specific operating costs of a particular distributor. The expenditure benchmarks were not and were not intended to be an assessment of the specific operating costs of a particular firm. They were a benchmark forecast of what an efficient firm might spend. The Reasons state this.
Accordingly, I do not accept that what the Office did in relation to the specific costs of each distributor, was not permitted by the mandated formula.
· Determination is cost based and not price based
It is correct that rate of return is a cost based method of price fixing. But the mere fact that costs are considered in a price fixing exercise does not make the exercise one of rate of return.
In my opinion, on a fair reading of the Determination and the Reasons and on the basis of the evidence of Mr Wilson, the Determination is not cost based. For reasons already stated, it was open to the Office to consider the specific costs of a distributor in applying the mandated formula, but this does not make the end result a cost based determination and not a price based one.
· Use of building block approach contravened prohibited formula
In its consultation paper No. 1, published in June 1998, the Office proposed a building block approach to the price review. There was discussion amongst interested parties, particularly from the distributors themselves, over the relative merits of a building block approach compared to a purely external benchmark approach. After considering all matters, the Office decided to adopt a building block approach.
At p.x of the Statement of Purpose and Reasons, the Office observed –
"In adopting CPI—X regulation, the Office has used a 'building block' approach which establishes the distributors' price controls on the basis of forward-looking revenue benchmarks reflecting the requirements of the distributors over the next five years.
These benchmarks are based on assumptions about efficient levels of expenditure that the distributors would need to incur over the 2001-05 period to meet the target levels of service reliability and quality, expected demand growth and the cost of capital financing. They are used to derive 'X' factors which, together with the Consumer Price Index, determine the annual percentage change in average tariffs. That is, average prices for the use of the distribution system will change by the CPI less the 'X' applying in that year."
(Emphasis added).
Criticism was made by counsel for TXU that the Office had misunderstood the mandated formula by equating CPI—X regulation with CPI—X approach. It is correct that throughout the Reasons, there is a tendency to refer to that part of a mandated formula as CPI—X regulation. However, on a proper reading of the Reasons, although the Office did from time to time refer to CPI—X regulation, in my opinion, the Office did not misunderstand the application of CPI—X approach. For the reasons already given, price based regulation meant price cap and in my opinion, the Office did not err in its approach to the task by referring to CPI—X regulation. In context, it is clear that the Office was adopting a methodology which was price cap CPI—X regulation, which equated with the terms of the mandated formula.
What must be understood at this point is that the building block approach to establish benchmark revenues did look at the financial positions of each of the distributors, but the benchmarks were established for each distributor by reference to an efficiently operated distribution business. It is not the actual business the benchmark addresses. It is the efficiently operated distribution business.
It is clear from the determination that the expenditure benchmarks were not, and were not intended to be, an assessment of the specific operating costs of any of the distributors. They are a benchmark forecast of what an efficient firm might spend.
At p.158 of the Determination, the Office noted –
"The essence of the 'building block' approach is that benchmark revenues for the next regulatory period are established with reference to forecasts of operating, capital expenditure and financing costs for an efficiently-operated distribution business. These benchmark revenues will be sufficient to enable efficient distributors to operate and invest in their networks, to service debts and to remunerate shareholders."
(Emphasis added).
If any distributors improved on what was expected of an efficiently operated distribution business, then the distributor was entitled to reap the benefit of the efficiency and/or increase in demand. To that extent, there is an in-built incentive element.
It can be said that a building blocks approach is something that is usually followed in a rate of return regulation, but the approach is looking at the particular supplier and determining for that particular supplier, its costs, anticipated revenue and ensuring a rate of return on its assets. The mere fact that a building block approach is also used in a price based regulation exercise does not make it rate of return regulation. Indeed, the evidence established that in practice, building block approaches have been used in both price cap regulation and rate of return regulation.
The important matters to focus on in the present proceeding are, the content of the building block approach, how it was used and in particular what was the result.
Again, in considering this ground of complaint, it must not be overlooked that cl.5.10(a) is not to be applied in a vacuum, and the balance of the clause together with the relevant provisions of each piece of legislation cannot be overlooked in the exercise.
The building block approach adopted by the Office in its price fixing review is forward looking, in that it looked at expected reasonable expenditure, it incorporated into the X more than the expenditure benchmark, namely, an efficiency carry over as well, it incorporated forecast industry characteristics and did not rely on the specific past performance of any distributor. Further, it did not determine the specific operating costs for a particular distributor, but created a benchmark forecast of what the efficient firm might spend, which created an incentive to earn more than what might be described as a reasonable rate of return for a particular distributor. On any view, the end result did not set a maximum rate of return, nor did it have any goal as a targeted rate of return, and if the distributor was able to do better than the benchmark revenues, the distributor was entitled to reap the benefit.
Further, the price controls did not provide insurance to the distributor as each bore the risk or reward of its business operation.
In addition, the exercise involved consideration of a number of factors which were external to the firm. The Office had regard to external benchmarking of expenditure forecasts in arriving at the benchmarks for the particular distributor. The expenditure benchmarks were not determined on the basis of each firm's actual costs. Consultants were engaged to consider closely all the evidence made available to it in order to establish the benchmarks.
Finally, it is clear that the price controls do not provide insurance to distributors, which is an important feature of rate of return regulation, nor did the determination permit a distributor to make application for a price review at any time, which is a very important feature of rate of return regulation. Admittedly, the Tariff Order ensures this prohibition on rate reviews before the end of at least five years, but the fact is that the determination made does not permit what is an important feature of rate of return, namely, review on request when circumstances change.
The building block approach adopted by the Office demonstrates that the building block model actually used was not traditional rate of return, and the evidence of the experts clearly supports that conclusion.
In my opinion, the use of the building block approach by the Office from which the X was derived, did not contravene the prohibition upon rate of return regulation, and was permissible and applicable in applying the mandated formula.
· The X factors should have been calculated on the basis of or having regard to external variables
This is a variation of the first ground of complaint considered above and does imply that the mandated formula did not permit regard to the specific costs of each distributor, but should have regard only to external variables. The ground can also be construed as requiring the Office to calculate the X factors on the basis or having regard to external variables such as changes in technology, demand and input supply prices.
For reasons already stated, it is my opinion that the Office was permitted to consider the specific costs of each distributor. However, the question now arises whether it was obliged by reason of the mandated formula to have regard to external variables.
In my opinion, it is clear – and this is amply supported by the evidence – that the mandated formula did permit reference to specific costs and, in any event, the balance of cl.5.10 and the two pieces of legislation required consideration of the specific costs of a distributor.
In so far as this ground asserts that regard should have been had to external variables, again the evidence demonstrates that the Office did have regard to external variables.
The task confronting the Office in considering external information was made difficult by reason of a number of matters. First, the privatised industry in this State had only been operating for some five years. Secondly, there was an absence of sufficient and reliable data to estimate the trends in the Victorian electricity supply industry. Thirdly, other trends in other regulatory jurisdictions would have to be closely examined to determine whether or not they had any value and, in particular, taking into account the differences in the network configurations of Victorian distributors. Fourthly, the Office would have to be wary, applying external information, bearing in mind that the configurations and operating procedures of each Victorian distributor was to some extent different. Finally, in any event, having regard to external information would have to be balanced with the obligation of the Office to give consideration to the specific firm's position, by reason of the Tariff Order and the Legislation.
Nevertheless, the Determination does record that in developing the proposed expenditure benchmarks, the Office did give consideration to information from interstate and overseas.
Page 53 of the Reasons records –
"In developing the proposed expenditure benchmarks in its draft decision, the Office undertook an extensive review of the distributors' forecast expenditure. It engaged consultants to report on the forecasts of network capital expenditure and network operating and maintenance expenditure and preliminary benchmarks of non‑network operating and maintenance expenditure and costs of FRC.
All expenditure studies undertaken by the Office's consultants for the review took account of benchmarks from interstate and overseas where available. Where this was not possible, weight was placed on comparisons between the distributors. The consultants conferred regularly to remove overlaps and gaps between their benchmarking studies."
(Emphasis added).
In my opinion this ground has not been established.
· The X0 was set without reference to the formula CPI—X
The ground not only asserts the above, but goes on to state that it was set solely by reference to individual firm required revenues so as to deliver an anticipated rate of return in year one.
Part III of the Reasons is concerned with price controls and at p.181 states –
"The Office has determined two X factors for each distributor as part of this determination:
· X0 (which represents the limit on the weighted average price change in 2001 (the first year of the new regulatory period)); and
· X1 which represents the limit on the weighted average price changes in each of the years 2002, 2003, 2004 and 2005."
The X factors applying to each distributor were set out in a table and, in respect of TXU, the X0 to apply was 21.8, which was the highest of all distributors. The X0 fixed for each distributor was between 12.9 and 21.8. In respect of the other four years, the X was fixed at 1.
On the re-determination, the X0 for TXU was reduced to 18.4.
At p.183 of the Reasons, the Office summarised the key features of the methodology used to calculate the X factors as follows –
"The Office has continued to set an X factor which is equal for each distributor for the years 2002 - 2005. Setting the X factor the same for each of the last four years of the regulatory period smooths the tariff revenue earned over these years, in contrast to the forecast revenue requirement, which moves more erratically.
The Office has set the X1 factor to equal 1%. This 1% level has been chosen to provide a relatively stable price path from 2002 to 2005, and to ensure that revenue earned in year five is close to the forecast revenue requirement for that year, given the value of X0.
The X0 factors have been calculated by setting the net present value (NPV) of the allowed tariff revenue over the period 2001 – 05 equal to the NPV of the forecast revenue requirement, for each distributor.
The revenue requirement has been determined by the building block approach as outlined in Part II.
In estimating future tariff revenue, the Office has used forecast quantities for each of the years 2001 – 05, for each of the distributors' tariff components, and multiplied these quantities by an assumed price for each tariff component. Setting the NPV of the tariff revenue equal to the NPV of the revenue requirement and assuming an X1 of 1% for the years 2002 – 2005 leads to an implied X0 factor for 2001."
The Reasons note that the Office used various assumptions regarding forecast quantities and assumed prices, used quantity forecasts for each distributor as a basis for the calculation of the X0 factors, and also calculated the X0 factors on the basis of the indicative tariff structure, the distributors proposed in their December 1999 submissions.
The main complaint of TXU is with reference to the setting of the X for the first year, and it contends that this drastic adjustment in the first year is inconsistent with a price based mechanism as it is typical of a rate of return approach.
The Tariff Order was silent as to the shape or profile of the price path over the five year period. It was a matter for judgment by the Office. It did consult with interested parties, including the distributors. In the end, the approach adopted by the Office in establishing the X factors was to ensure that the combination of the X factors chosen for each year of the five year regulatory period was such, that based on forecast demand, each distributor could be expected to earn revenue over the period at least equivalent to the forecast total revenue benchmark. Again, I emphasise the benchmark was that expected of the efficient distributor.
Various options were put forward and in the result, the Office adopted the option of re‑setting prices for the first year of the new period with a constant X factor for the following years. It did so on the basis that the X0 adjustment in the first year followed by a constant X factor for the subsequent years provided a stable price path over the period, which would have the result of facilitating a smooth price path into the next review period.
According to the evidence of Mr Wilson, the adoption of an X0 factor was equivalent to re-setting the prices at the start of a new regulatory period. That is, the X0 adjusts the prices so that the initial prices are set to enable the distributor to at least achieve the forecasted benchmark revenues in each year. He stated –
"The advantage of re-setting prices by way of an X0 factor rather than specifying new starting period prices is that it provides greater flexibility to distributors in determining the prices for particular network tariffs."
It is important to emphasise that this complaint must be examined in relation to the fact that the Determination fixes the adjustment mechanism for five years. The question is whether the fixing of X0 being different to the other years, is permitted in a price based CPI—X regulation method?
The evidence does support the conclusion that a large X0 adjustment is consistent with a price cap regulation using a CPI—X approach.
A price based regulation adopting CPI—X approach is an incentive based price fixing method. The means by which the objective is achieved is a matter for the judgment of the regulator. In principle, there is no reason that in fixing prices over a five year period, adjusted by a CPI—X approach, the regulator cannot set a large adjustment mechanism for the first year. Indeed, Professor Littlechild did that in regulating the UK electricity distribution prices. His approach was to reduce the prices immediately and not use a glide path. But in doing this, as he observed, he was not constrained by not using rate of return. However, it clearly was an acceptable step in the price cap approach.
But is it a rate of return regulation? Does it result in the prices not being incentive based?
One must look at the totality of what was done over the five year period. What the Office did leads to the conclusion that it used an incentive based regulation. But in any event, a large X0 figure does not mean there is no incentive. On the question of incentives, as Mr Ergas points out, a large and immediate price cut would focus management attention on securing immediate efficiency improvements. This would be to maintain the current position. Further, the initial price cut will not have any effect upon the efficiency towards the end of the regulatory period. I accept what Mr Ergas said when he stated –
"Thus, P-nought adjustments are not per se inconsistent with incentive based regulation. The immediate impact (of a price cut) can provide efficiency incentives and the medium term impact will depend on the other aspects of the regime. In our view, the efficiency carry over described in the determination at issue, is effective in lengthening the time horizon over which efficiency incentives operate beyond what would occur in a price cap regime without such a provision."
The evidence establishes that a large X0 is consistent with a CPI—X approach price cap regulation in circumstances where events are windfall or uncontrollable. Professor King agreed that a large X0 may be appropriate for exogenous changes.
In my opinion, the evidence overwhelmingly leads to the conclusion that a large X0 is consistent with using a price cap approach and that it has been used by other regulators applying a price cap regulation approach.
·An efficient carry over would have been unnecessary if the X factors were set on basis of external factors only
This ground appears to be saying that an efficiency carry over would have been unnecessary if the X factors were based on external factors and therefore, it must follow that the price determination was not price based regulation adopting a CPI—X approach.
Logically, that complaint cannot be correct. The mere presence of an efficiency carry over does not mean that the price was not determined in accordance with the mandated formula.
The introduction of an efficiency carry over mechanism was to address the incentive concerns which may arise during the final year of the review period, when there is a temptation for the distributor to not work as efficiently because of the impact good results may have in the final year on the regulator for the next period.
The Office, in the Reasons, stated the objective of an efficiency carry over mechanism as follows -
"An efficiency carry over mechanism is an increment to the benchmark revenue requirement that provides a distributor with an additional share of the benefit from any efficiency gains achieved during the previous regulatory period. The objectives of such mechanism are:
· to encourage distributors to pursue efficiency gains through the regulatory period, which in turn reduces prices to customers (in present value terms); and
· to reduce the incentive to defer the pursuit of efficiency gains that might otherwise exist immediately before a regulatory review."
The model adopted by the Office was described by it as follows –
"The long-term carry over mechanism provides distributors with a greater incentive to make efficiency gains that would apply under the CPI—X regime alone. It also counteracts incentives that would otherwise exist for distributors to defer efficiency improvements in the years immediately preceding a regulatory review. That is, the mechanism provides a consistent incentive to achieve cost reductions in every year of the regulatory period. The service incentive mechanism ensures that this incentive to achieve cost reductions is not at the expense of service quality. Together, the efficiency carry over mechanism and the service incentive mechanism align the distributors' incentives with the Office's objectives facilitating efficiency in the electricity distribution industry and ensuring that the interests of consumers with respect to reliability and quality of electricity supply are protected."
That is what the Office set out to achieve, and did achieve, and the efficiency carry over was all part and parcel of an incentive based price regulation approach. The approach accords with cl.5.10(d)(i) and the objectives in the legislation.
Further, the evidence established that the efficiency carry over was not part and parcel of a rate of return regulation approach. I accept the evidence of Mr Ergas when he says –
"The efficiency carry over is utterly inconsistent with rate of return regulation. If a distribution business finds a way to provide the same level of service with fewer costs, its profit rises. Thus the rate on return assets increases. Under rate of return regulation, such a firm would expect that its prices would be cut by way of price review. If this were not done, the firm's rate of return would not be, being regulated.
In the determination at issue, the firm is permitted to earn the resulting higher rate of return for a minimum of five years, after which it begins to share the subsequent gains with the consumers. There is no claw back of the super profit collected by the firm during the first five years. Thus, there is no sense in which the firm's rate of return is regulated over this horizon."
In my opinion, this ground has not been made out.
CONCLUSION
The attack upon the Determination is that the method used to fix the prices did not utilise a price based regulation adopting CPI—X approach. I have considered each ground of complaint and in my opinion, the plaintiff TXU has not established that the Office did not use the mandated formula. On the contrary, it is clear that the Office set out to establish a price, based on price based regulation adopting a CPI—X approach, and achieved what it set out to do.
In my opinion, the price fixing methodology was incentive based and so was the result. It was not rate of return methodology.
The Office clearly understood the essential differences between the mandated and prohibited formulae, and in fixing the prices steadily kept the differences in mind.
At p.159 of the Reasons, the Office stated –
"The essential difference between price based or CPI—X regulation and a rate of return approach is the period of any determination and the incentives that this gives rise to. CPI—X regulation offers financial rewards to distributors that improve their long term cost efficiency at a rate faster than predetermined benchmarks embodied within a CPI—X regulatory regime which applies for a specified regulatory period. On the other hand, under rate of return regulation, prices are adjusted whenever necessary to ensure the regulated entity earns a specified return on its invested capital. Rate of return regulation does not offer the same rewards for outperforming benchmarks, and so the incentives for efficiency improvement are much less."
The determination made by the Office gave effect to the long term efficiencies expected of the distributors and their right to reap the benefit of their efforts. They are not permitted to apply for reviews whenever the prices change. In my opinion, the price determination was not made pursuant to a rate of return regulation approach.
In my opinion, the plaintiff has failed to prove the Determination was made without power. On the contrary, I am satisfied that the Office made the determination in accordance with the Tariff Order and the relevant provisions of the legislation, and within power. The proceeding should be dismissed with costs.
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CERTIFICATE
I certify that this and the 86 preceding pages are a true copy of the reasons for judgment of Gillard J of the Supreme Court of Victoria delivered on 17 May 2001.
DATED this seventeenth day of May 2001.
Associate
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